Macro Headwinds Could Take Their Toll On Philip Morris In 2015


Philip Morris International (NYSE:PM)

Philip Morris International Inc., through its subsidiaries, manufactures and sells cigarettes and other tobacco products. The company’s portfolio of brands include Marlboro, Merit, Parliament, Virginia Slims, L&M, Chesterfield, Bond Street, Lark, Muratti, Next, Philip Morris, and Red & White. The company sells its products in approximately 180 countries in the European Union, Eastern Europe, the Middle East, Africa, Asia, Latin America, and Canada. Philip Morris International Inc. was incorporated in 1987 and is headquartered in New York, New York.

The company’s five-year price to volume performance can be seen below:

Financial Highlights (FY end Dec)

Four key markets have been having a significant effect on the earnings of the company. These include the EU, Russia, Japan and South Korea.

Sales volumes in the EU are beginning to decelerate again. Nielsen EU cigarette data (UK, Italy, Spain, Germany) show that overall PM volumes had rebounded to 5.0% in 2Q14 following mid-single-digit declines in 2013. However, recent data has shown volumes beginning to decline y/y for 4Q14. Moreover, by market PM has experienced mixed sale share trends, with share growing in Italy and Spain but decreasing in the UK and Germany. This trend has been exogenous from foreign exchange fluctuation.

Russian data suggests a tough industry volume environment, with Phillip Morris comparatively outperforming. Nielsen Russia cigarettedata (~9% of company sales) show the impacts from a 8 Rubles/pack excise tax hike in January 2014, with PM pricing +25% and volume declines accelerating to -9% in October. However, by PM brand, Bond Street has performed comparatively well, posting +100 bps sales share gains in 3Q14 against others such as JT, BAT and IMT.

Japanese industry shipments have declined, with limited offset from pricing. Tobacco Institute of Japan tracked industry shipments show declines of 3.5% through November, while non-JT volume share has bounced back from early 2014, but is not growing above the 40% level.

Korea faces increased headwinds following a dramatic tobacco tax hike on January 1st 2015. In Korea, KT&G and PM have decided to take a 2000 Korean Won per pack price increase for the majority of their products across various price tiers, which effectively translates to 4-36% increase in manufacturer’s ASP. Korean market volume could decline ~25% in FY15 post price increases with a 50 bps overall profit impact for PM.

Company Outlook

Macro drivers are likely to be a serious factor affecting company earnings in the coming year. While the US has been a global bright spot and GDP growth rates are estimated to rise to 3% in FY15, the company still remains exposed to markets that are likely to underperform in comparison to the rest of the world. Russia and Japan alone make up approximately 20% of the company’s profit and they are both expected to be near the bottom of economic growth in developed countries. Currency concerns, especially in Russia, will be a major focal point for management.

Philip Morris also faces challenges in some of its key markets exogenous from overall macro risk. 2014 was year that focused on investment and the company still faces challenges. Japan’s industry volume in 2014 has been down 3.5%, with limited pricing to offset volume declines, Korean prices will be driven up 80% because of tax hikes, and Russia is being hammered with both tax increases and a depreciating ruble.

Foreign Exchange impact on sales translation is widely understood, analysts believe FX’s negative margin impact, and particularly in PM markets such as Japan and Russia where significant transaction exposure is less appreciated. Analysts believe PM sales in Russia will decline 35% and profit almost 50% in 2015. In addition, as PM pays dividends and buyback stocks in $US, with an already high 85% dividend payout ratio (limited upside), the company’s cash flows are now becoming a concern.

Economic Moat Trend

Emerging markets are still key as tobacco is still widely accepted, and there remains a large untapped market. While up-trading has slowed in certain markets, there is no evidence of widespread consumer trade-down in the tobacco sector and the effectiveness of product innovation remains.

PM operates in an inherently attractive industry, with high profit margins and substantial free cash flow. The company benefits from significant geographic diversification with good exposure to emerging market (growth) and developed markets (high margins). Product innovation and cost saving realization are improving and analysts anticipate continued long-term improvement in PM’s local currency operating results, driven by a general absence of excise tax shocks and good industry pricing.

As shown in the chart below, the margins in the industry are still incredibly attractive. Net profit has remained strong between 25% and 30% for the past 10 years.

Major Risks

  1. Tax regulation changes will always remain a concern for the company. Many developed markets consistently raise taxes on tobacco products to try and influence their citizens away from an unhealthy product.
  2. Increased awareness of the risks associated with tobacco use in emerging markets could curtail the growth opportunities in these markets
  3. Macro outlook concerns particularly in the EU, South American and Russia.

Investment Rationale

Analysts expected PM’s stock to be a relative underperformer within the consumer staples industry as current business environment favours US-exposed names, oil beneficiaries, secular growth and self-help/strategic optionality stories, none of which fit PM’s profile. Although macro/FX risks are widely known by investors, there remains significant potential for further relative P/E compression given another year of sizable EPS decline and a lack of company-specific catalysts.

PM currently trades at $82.39 (price as of Feb 11th) potential remains for the company to trade downward on the basis of headwinds related to macro and FX exposure. The Vuru DCF growth price for the company is currently 32% below where the company currently trades. Some of this can be explained by the premium that is placed on this company being one of the leaders in the market. However, the significant exposure this company has to risks in 2015 could lead this company to trade down below its current price at the end of year.